[Newsphopick=Kingsley Lim] At some point, investors have heard the mantra that one could make money whether the markets go up or down. Is that true? Well, to some extent, when you hear such things, it is typically a “hook” to get you to buy something. But of course, there is also truth to the statement. One can make money in the stock market whether it goes up or down.
The most straightforward way of course is to make a bet on the direction of the economy or the securities that one intends to invest in. So if you believe that Company A’s share price is going to rise by 50% over the next 6 months, as Tesla had done over the last six months, then it would make sense to buy stock in the company and wait for it to appreciate. If one is right, he earns a profit of 50% with a stock purchase.
If one predicts that Company A would fall by 50% over the next 6 months, one could borrow the shares through a broker, and then buy it back when the share prices have fallen. In this way, one buys at a low price and sells at a high price – pocketing the difference as profit.
But what if I told you that you could make money in the stock market regardless of the direction of the markets or the security. You don’t have to know the direction to make money. This sounds absolutely ridiculous but let me assure you that it is based on sound mathematical principles. Amongst the barrage of option strategies, one would find a strategy that is called the long straddle strategy.
In this strategy, one need not know the direction of the security but one needs to know that there is likely going to be a significant change in price of the security that would happen sooner rather than later. In other words, one is concerned about the magnitude of the move but not the direction of the move.
How to execute a long straddle options strategy?
Referring to the chart above, one would realise that there is a loss-making zone where the strategy loses money. But outside of these zones, the straddle is a potential money maker.
If the price of the security goes up, the call option portion allows one to collect unlimited profit. If the price of the underlying security goes down, the put option will allow one to collect a limited profit as the lowest a share price can go to is zero. But if you look at it mathematically, profits are unlimited to the upside while limited to the downside. Losses however is limited to the option premium paid. So one’s risk to potential return can be quite favourable with analysis.
According to a very good resource, OptionsManual.com, one could initiate a long straddle by buying one at-the-money put option and one at-the-money call option. This would allow one to take profit from large percentage rises or falls of the underlying security.
If the price of the underlying security falls drastically, one would make a profit. If the price of the underlying security rises significantly, one would also make a profit. However, if the price of the underlying security does not move much, and stays constant, the trader or the investor will lose his investment – the premium paid for the options.
By way of example, the trader may have to pay $2 to buy an at-the-money call option and $2 to buy an at-the-money put option. When that happens, he pays $4 in total to initiate the long straddle options strategy. Hence, the underlying security must move by more than $4 in order for the trade to be profitable. Hence, your analysis must point towards large moves in the underlying security.
By way of a crude example, perhaps, a stock is overvalued but no one knows when the correction will occur. But on the other hand, there is an upcoming earnings announcement that could possibly propel the stock higher by 20% to 30% based on your estimate of earnings. But if it disappoints the market, perhaps due to the COVID-19 situation, it is highly likely that the price of the stock will fall from a price-to-earnings ratio of 30 times to 20 times.
This may lead to a correction of at least 30%. If the earnings does worsen, the fall in price could be close to 40% to 50%. So these things are a matter of probability but you could take the risk if it made sense. One could initiate the long straddle at a price of $4 and if it does move up by $30, one makes $26 in profit. If it moves down by $50, a good pay day profit of $46 awaits!